Monday, July 11, 2011

Day 270: How to Pay Off Debt: Lowest Balance or Highest Interest Rate?

Have you set a goal to become debt free but not sure how to do it? Should you pay off the highest interest rate debt first or work the snowball and pay debts off in order of smallest to largest balance? Well, the answer is clear as mud - it depends. Let's take a look at this question from a few different angles. Today in Part I, I'm going to look at this question purely from a numbers perspective.

The Numbers
First, full disclosure: We use the snowball approach and pay off debts from smallest to largest balance. I keep a spreadsheet that tracks the monthly debt payments we make and also estimates which portion of these payments go to interest and principal. That way I can forecast when I expect each debt to be paid off. So how much extra money am I having to pay in interest by using the snowball? Based on our actual first 270 days of payments and estimating the last 95 days of payments, the difference is a whopping $76 bucks.

After doing this calculation, I convinced myself that the snowball method was
definitely the way to go. But take a look at my fact pattern - the
difference between my lowest and highest balance is about $11,000 (I didn't include the debt we paid off on Day 1 since there is essentially no interest involved this year). But
my interest rate spread is only 0.3% (4.55% - 4.25%). I decided to try the calculation again but make the loan amounts all the same and change the interest rates to reflect a more significant spread. Note: By making the loan balances the same I am removing the snowball method option and purely focusing on the impact of interest rates on loan payments. In this scenario, I assumed that all loan balances are $20,000 and the
interest rates are 4%, 8% and 12% - a spread of 8%. I also assumed a
monthly payment of $3000. If I pay the debts off from lowest to highest
interest rate I pay $1,923 more in interest than if I had started with the highest interest rate debt.

Wow!! I can honestly say I didn't think it would be this much of a difference, especially with an accelerated payoff time due to the large amount of money going towards monthly debt payments.

The Takeaway
So what am I trying to prove? Well, mainly that every person has a different fact pattern and without an attempt at forecasting out your debt payoff you may be completely in the dark (like me) on whether your method will end up costing you $5 or $5,000 in extra interest payments.So know your fact pattern for each debt:
1) loan balance
2) interest rate
3) monthly minimum payments
4) term of loan
5) estimated total monthly debt payments you can afford

Next, create your forecast. See how long it will take you to pay off your debt and test out multiple payoff scenarios to help you figure out which may work best for you.

Not sure how to create a forecast?Send me an email with your fact pattern (see #1-5 above) and I am happy to help you model it out. Or I can send you the Excel spreadsheet I used and you can model it out yourself.

Frugal Student, you definitely have a point. Similar to my example, not paying the highest interest rate debt first can add on extra money to your debt payoff plan. If that works, great! But depending on the situation, there may be alternatives that work better for a person from a behavioral standpoint. The success of Dave Ramsey's plan and his loyal following is a testament to that.